Plenty of people and institutions fail as investors – there is no two ways about it. There is however an abundance of reasons why they do so (as it turns out Investing is pretty hard, who knew?) and many of them are actually quite interesting to think about, especially when they start involving questions about the nature of the market itself. After all, who does not love a good rant about EMH, active vs. passive or good old animal spirits?
In this post I am not going to talk about any of them.
Instead I want to address the far more mundane but crucial role of proper financial planning in investing. Yes, that is right, I am fun at parties.
What is financial planning? Bluntly put it is the taking of adequate measures (e.g. saving) to ensure that at no point one’s financial obligations (i.e. expenditures & debt) exceed one’s ability to satisfy them (via income & assets). Successful financial planning balances one’s limited resources with as many of one’s personal goals and desires as possible without ever jeopardizing the fulfillment of all needs. Ultimately this enables the individual to lead a lifestyle that is both fulfilling & provides a high quality of life (relative to their means) and is sustainable in the long-term.
To understand what sustainability in the long-term has to do with volatility related risks, we need to look at the rationale behind investing in the first place. A rational agent chooses to invest because they expect their investments to return on resources employed (principal, time, effort) at a rate that is satisfactory compared with all other available alternatives over the chosen time period. There is only one scenario wherein an investor like this can be negatively affected by the volatility of their investments unrelated to their underlying performance: They choose to sell at an inopportune time (that is to say they abandon a position at a level of valuation which prices it below its reasonably expected value based on fundamentals). Note that this does not necessarily mean a net loss in absolute terms but rather underperformance compared to simply maintaining the position. Why would a rational agent that is aware of the true value of their position ever choose to sell at a sub-optimal price? Well, they would not… Unless they were forced to.
How might an investor be forced to prematurely liquidate their holdings? The answer is simple: they need money to cover their obligations. It does not matter why they need the money, if it is because of life-saving heart surgery, insufficient collateral for positions on margin or needing to pay rent, the outcome is the same: underperformance compared to the potential returns of the investment. This is especially damaging from the fundamental investor’s point of view because they are entering positions that are (ideally of course) under-priced and that tend to appreciate nonlinearly over time (as they are better understood or more correctly valued for other reasons) rather than linearly (an investment growing and performing in line with expectations/valuation). In other words, investments are by necessity volatile and if you have to leave the ship at the wrong time, you will get wet, even if it does end up reaching the harbor.
My point is that akin to real life, under good or mediocre conditions you are the biggest threat to your own well-being even if you are perfectly rational (which you are not, cue the ghost of Leonard Nemoy glaring disapprovingly). By taking a conservative approach and investing only what you can afford to lose without having to reduce your standard of living, volatility on its own will never impact your decision making as an investor. Doing so will not automatically cause your investments to be a success but letting volatility affect your decisions is a sure-fire way to snatch defeat even from the jaws of victory.
And you do not want that, now do you?
Tom
The Financial Flâneur 